New OTC derivatives world could see collateral squeeze, say industry experts

Over-the-counter (OTC) derivatives structurers operating in the new Dodd-Frank and European Market Infrastructure Regulation (EMIR) world will need to shell out more collateral in the form of cash and high-quality assets to prevent systemic risks, industry experts said. A greater risk is the danger of a collateral squeeze caused by a reduction in high-quality assets and compounded by a surge in demand for such assets, said Kishore Ramakrishnan, senior manager, financial services advisory at Ernst & Young in Hong Kong.

The recently published International Monetary Fund (IMF) Global Financial Stability Report highlighted a grim scenario in the new OTC derivatives world, following sweeping global regulatory reforms. Specifically, it pointed out two main factors that might contribute to a surge in demand for collateral: the widespread adoption of central counterparty clearing (CCP) and Basel III’s liquidity coverage ratio (LCR). The IMF estimated that more than 80 percent of OTC derivatives transactions would need to depend on the use of collateral. This estimate was based on a 2010 finding which showed that 80 percent of collateral that backed up the global OTC derivatives trades was in cash, with around 17 percent of that collateral being government securities.

Liquidity could dry up
Ramakrishnan said that posting high-quality assets such as government bonds or anything as liquid as cash could potentially lead to liquidity drying up. He cited the results of the International Swaps and Derivatives Association (ISDA) 2011 Margin survey which showed that around 80 percent of all OTC derivatives trades executed by the world’s 14 largest dealers were subjected to collateral agreements. Cash used as collateral represented 80 percent of collateral delivered in 2010, while government securities such as U.S. Treasuries, UK gilts, Japan government bonds (JGBs) constituted 10 percent of collateral received and 17 percent of the collateral delivered, according to the survey.

“This means that there will be a huge demand for high- and good-quality assets to the dealers, and yet on the other hand the quality of liquid assets has reduced because a lot of the sovereigns are now in crisis. So the problem is compounded by the demand which will surge and that has resulted in what we called a collateral squeeze”.

Collateral coming out of the dark
Collateral management, according to Ramakrishnan, has traditionally been viewed as a cost centre and is generally not seen as generating revenue for banks. But the OTC derivatives industry has seen a transformation in the last four to five years for a number of reasons, he said. “The way the OTC derivatives business works now is that banks are now required to streamline their collateral management and it has come out of the shadow of a back office function and is being considered as a revenue-generating stream akin to front office trading desks. From that point, collateral management and collateral transformation services have taken the spotlight and it is now embedding itself into the starting point of OTC derivatives cycle instead of as an end point,” he said.

“But the global OTC derivatives regulations from Dodd-Frank Act to the European Market Infrastructure Regulation all the way to various local regulations in a number of jurisdictions in Asia, including Japan, South Korea, Singapore, Hong Kong and Australia, all pointed out the need for banks to streamline their collateral management in order to run their OTC derivatives business,” Ramakrishnan said.

The fact that collateral has become so much sought-after is a new phenomenon, and one which has come about largely because of the global OTC derivatives regulatory reforms, in particular the need for OTC derivatives trades to be cleared through CCPs required by the new OTC derivatives regulations, as well as the new Basel III capital and liquidity requirements.
“The shift to a CCP regime will elevate the collateral demand by between $100 billion to $200 billion for initial margin and guarantee funds, thereby directly reducing the ability to rehypothecate or re-use the collateral. This in turn would intensify the [need for] financial institutions to scout for alternate ‘collateral’ assets to meet the desired aggregate funding volumes,” Ramakrishnan said.

Impact of Basel III on OTC derivatives business
He said the impact of Basel III on the OTC derivatives business could not be underestimated as it adds strain to high-quality assets. “Basel III requires at least 60 percent of banks’ tier-one capital to be in the form of cash and government bonds, and up to 40 percent of their tier-two assets would need to be highest rated corporate bonds in order to meet the LCR requirements. Furthermore the quality of high-quality assets is reducing because many countries are now in sovereign crisis. The question then to ask is: what if the proportion of tier-2 assets are increased to meet a critical component of LCR requirement? Say if the LCR is increased to 45 percent, you can imagine how much it will be a squeeze on assets to the banks. It would also be interesting to see if the definition of tier-2 assets will be broaden to include a broad range of corporate bonds and perhaps equity assets. OTC derivatives regulations such as the Dodd-Frank Act, EMIR and other Asian regulations have all spiked the demand for collateral assets,” Ramakrishnan said.

Although the new OTC derivatives regulations have given rise to what is known as clearable standardised OTC derivatives trades, non-cleared bilateral trades, according to Ramakrishnan, would still be subjected to huge capital and margin requirements. “Non-cleared bilateral OTC derivatives trades would still be subjected to capital and margin requirements as appropriate weightages would have to be assigned to such OTC transactions as prescribed under the Basel III regime. For standardised trades that will be cleared through CCPs, they will be subjected to variation margins,” he added.

With the implementation of mandatory clearing of OTC derivatives — originally scheduled for January 2012 — taking longer to achieve, Peter Connor, head of markets clearing Asia Pacific at Deutsche Bank Global Markets in Sydney, said the market has focused on Basel III and its requirements for banks to hold a lot more capital against OTC derivatives trades. The impending Basel III framework, he added, would instead create the economic incentives for transactions to be centrally cleared.

“Basel III introduces a Credit Value Adjustment (CVA) and in some instances this will require banks to hold substantially more capital against bilateral OTC derivatives trades. Banks now have to assign capital against the assets created by client’s mark-to-market losses in their derivatives portfolio. The cost of this additional capital will be reflected in the price of the transaction, and therefore it will be passed on to counterparties unless the transaction can be centrally cleared and the CVA charges avoided”.

Economics will drive business
Connor said because of the additional capital requirements, the economics of doing OTC derivatives trades would eventually drive the business, which he added would be of particular concern to the second and third tier market players. “Now clients have to make sure that they have the clearing capacity, including having the provider, the legal operations set out as well as having clearing and collateral in place. All this will take a minimum of three months depending on whether they have the systems and software,” he said.

Connor said with the additional capital requirements under Basel III coming into force in 2013, the economics of executing bilateral OTC derivatives trades could begin to drive greater volumes into CCPs. He pointed out that the major dealers would join the CCPs directly, but many of the second and third tier market players would need access to the CCPs via a client clearing arrangement.

“Many of our clients are working hard to make sure that they have the capability to clear OTC derivatives transactions. This requires input from the risk and operational functions within an organisation. Furthermore, if clearing into a CCP means clients have to post collateral against their OTC derivatives portfolio for the first time, this could have significant impact on the organisation. This is because they would need to ensure the they have sufficient eligible securities and cash available,” he explained.

Ramakrishnan agreed and pointed out that the second and third tier players in the OTC derivatives market such as asset management companies and the corporate sector, which lack deep pockets unlike the top 10 dealers such as JP Morgan, Goldman Sachs, and UBS, are beginning to question if it would be worthwhile for them to be in the OTC derivatives business as a means to hedge their risk such as interest rate risk and credit risk exposures. This is because clearing through a CCP requires huge amount of capital up front which will go into registering as a clearing member, as well as paying for initial and variation margins, and default funds to the CCP. “They are now thinking of using alternative financial products which will reduce their regulatory burden and yet efficient and able to hedge their credit risk and interest rates swaps risk, and also less stringent when it comes to collateral management, with lower capital requirements,” he said.

Ramakrishnan said official statistics had shown that of the $700 trillion of notional outstanding OTC derivatives business, about 90 percent of them were covered by the top 10 dealers, with the remainder being handled by second or third-tier players.

New revenue stream for top dealers; new financial innovations
Industry players said, however, that not all was doom and gloom in the new OTC derivatives world. For the top dealers at least, client clearing would be a new revenue stream as second and third tier players which lack the capital to clear their trades through CCPs would look to the top dealers to clear their trades. Connor said institutions with strong credit ratings, global reach to CCPs across many markets, and a strong risk management culture are best placed to provide client clearing services.

Ramakrishnan, on the other hand, believed that the new regulations would see an emergence of new financial innovations, such as exchange-traded funds, which could help OTC derivatives players hedge their credit and interest rate risks.